CFC vs PFIC: Key Differences and Tax Implications

U.S. taxpayers who own interests in foreign corporations are subject to specific anti-tax-deferral regimes from the Internal Revenue Service (IRS). These rules are designed to prevent U.S. persons from indefinitely deferring U.S. taxation on profits generated through foreign entities. Two of the primary regimes are the Controlled Foreign Corporation (CFC) rules and the Passive Foreign Investment Company (PFIC) rules. Each classification carries its own definitions and ownership thresholds, and understanding which set of rules applies is an important step for any U.S. investor with foreign holdings, as it dictates how and when foreign income is taxed.

Defining a Controlled Foreign Corporation (CFC)

A Controlled Foreign Corporation (CFC) is a foreign entity whose ownership is significantly concentrated in the hands of U.S. persons. The classification is based on the level of control exerted by its American owners, not the type of business it conducts. The definition relies on two ownership tests to determine if a foreign corporation meets the CFC criteria.

The first step is to identify any “U.S. Shareholders.” As defined in Internal Revenue Code (IRC) Section 951, this is a U.S. person who owns 10% or more of the foreign corporation’s stock. The 10% threshold is measured by either the total combined voting power or the total value of all shares.

A foreign corporation is classified as a CFC under IRC Section 957 if more than 50% of its stock is owned by these U.S. Shareholders. This measurement is also based on either voting power or total value. This test only considers the ownership of U.S. Shareholders, meaning a U.S. person owning 9% of the stock would not count toward the 50% threshold.

The IRS also applies stock attribution rules found in IRC Section 958. These “constructive ownership” rules mean a person can be treated as owning stock that is legally owned by a related party. For instance, stock owned by a foreign family member can be attributed to a U.S. person, potentially making them a U.S. Shareholder and tipping the corporation into CFC status.

Understanding a Passive Foreign Investment Company (PFIC)

The Passive Foreign Investment Company (PFIC) regime can apply to a wide range of foreign entities, including foreign mutual funds and certain holding companies. Unlike CFC rules, PFIC status is determined by the nature of the corporation’s income and assets. There is no minimum ownership threshold for a U.S. person to be subject to the PFIC rules; holding even a small share can trigger these tax implications.

A foreign corporation is classified as a PFIC under IRC Section 1297 if it meets either of two tests. The first is the Income Test, which is met if 75% or more of the corporation’s gross income is passive. Passive income includes:

• Dividends
• Interest
• Royalties
• Rents
• Annuities
• Net gains from the sale of assets that produce this type of income

The second path to PFIC status is the Asset Test. A foreign corporation meets this test if at least 50% of the average value of its assets held during the year are assets that produce or are held for the production of passive income. If a U.S. shareholder owns stock in a company when it qualifies as a PFIC, the stock remains tainted as a PFIC for that shareholder’s entire holding period, even if the company ceases to meet the tests in later years. This taint can only be removed through specific tax elections.

Tax Treatment of CFCs

The tax implications for a U.S. Shareholder of a CFC are centered on anti-deferral. Instead of waiting for the foreign corporation to distribute earnings, the tax system requires certain income to be included in the shareholder’s return annually. This creates “phantom income,” where a shareholder owes U.S. tax on profits they have not yet received. The two primary income categories that trigger this are Subpart F income and Global Intangible Low-Taxed Income (GILTI).

Subpart F income, defined under IRC Section 952, targets passive income and other earnings considered easily movable to low-tax jurisdictions. This includes foreign base company income, which encompasses passive earnings like dividends and interest, as well as certain sales and services income from transactions involving related parties. Each U.S. Shareholder must report their pro-rata share of the CFC’s Subpart F income.

The GILTI regime, under IRC Section 951A, acts as a global minimum tax on CFC earnings. It is calculated by taking the CFC’s total income and subtracting certain items, including Subpart F income and a 10% return on its tangible business assets. The remaining income is the shareholder’s GILTI inclusion, which is taxed at ordinary income rates.

Corporate shareholders are eligible for a 50% deduction on their GILTI, a figure scheduled to be reduced to 37.5% for taxable years beginning after December 31, 2025. Corporations can also claim foreign tax credits to offset the U.S. liability. Individuals can make a special election to be taxed as a corporation for their CFC income to access these same benefits.

Tax Treatment of PFICs

The tax treatment for owning stock in a PFIC can be punitive without proper planning. The IRS provides three different methods for taxing PFIC investments, and the choice of regime alters the tax outcome. If a shareholder fails to make a timely election, they are forced into a default regime with high tax rates and interest charges.

The default method is the Section 1291 fund, or “excess distribution” regime. This treatment applies to any gain from selling PFIC shares or upon receiving an “excess distribution,” which is the amount of a current year’s distribution that exceeds 125% of the average distributions from the prior three years. The gain or excess distribution is allocated ratably over the shareholder’s entire holding period. The amounts allocated to prior years are taxed at the highest ordinary income tax rate in effect for those years, and an interest charge is applied.

To avoid the Section 1291 regime, a shareholder can make a Qualified Electing Fund (QEF) election under IRC Section 1295. This election must be made in the first year of ownership and allows the shareholder to be taxed more like a partner in a partnership. Each year, the shareholder must include their pro-rata share of the PFIC’s ordinary earnings and net capital gains in their income, regardless of whether any cash is distributed. A QEF election requires the PFIC to provide the shareholder with a “PFIC Annual Information Statement,” which many foreign funds are unable to provide.

A third option, available only if the PFIC stock is “marketable,” is the Mark-to-Market (MTM) election under IRC Section 1296. Marketable stock is stock regularly traded on a qualified national securities exchange. Under an MTM election, the shareholder includes the annual change in the stock’s fair market value in their income as ordinary income. If the stock value decreases, the shareholder can claim an ordinary loss, but only to the extent of previously included MTM gains.

The Overlap Rule and Reporting Requirements

A foreign corporation can simultaneously meet the definitions of both a CFC and a PFIC. To address this, the tax code provides the CFC-PFIC Overlap Rule. This rule gives precedence to the CFC rules over the PFIC rules. For a U.S. person who qualifies as a 10% U.S. Shareholder of a CFC, the corporation is not treated as a PFIC with respect to that shareholder. This means a U.S. Shareholder will follow the Subpart F and GILTI tax rules and will not be subject to the PFIC regimes for that same investment.

Compliance with these rules requires diligent reporting on specific IRS forms. U.S. Shareholders of a CFC are required to file Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” This return requires reporting on the CFC’s financial statements, ownership structure, and related-party transactions.

Shareholders of a PFIC must file Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.” A separate Form 8621 is required for each PFIC owned. Even if a shareholder qualifies for the CFC-PFIC overlap rule, they may still have a Form 8621 filing requirement in certain situations.